An accounting method is a set of rules used to determine when and how income and expenses are reported. A farmer’s accounting method includes not only overall method of accounting, but also the accounting treatment used for any material item.
A farmer can use any of the following accounting methods:
- Cash method.
- Accrual method.
- Special methods of accounting for certain items of income and expenses.
- Combination (hybrid) method using elements of two or more of the above.
Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting.
A farmer can account for business and personal items using different accounting methods. For example, a farmer can figure his/her business income under an accrual method, even if s/he uses the cash method to figure personal items.
Similarly, if a farmer operates two or more separate and distinct businesses, s/he can use a different accounting method for each. However no business is separate and distinct unless a complete and separate set of books and records are maintained for each business.
Most farmers use the cash method since they find it easier to keep records using the cash method. However, certain farm corporations and partnerships and all tax shelters must use an accrual method of accounting.
Under the cash method, all items of income actually or constructively received during the tax year should be included in the gross income. If property or services is received by a farmer, s/he must include their fair market value in income.
A cash method farmer’s gross income for the tax year includes:
- cash and the value of merchandise or other property received during the year from the sale of livestock and produce raised;
- profits from sale of purchased property and livestock;
- fees received from breeding, renting teams, machinery or land, and other incidental farm income;
- all taxable subsidy and conservation payments received; and
- gross income from all other sources.
Income is constructively received when an amount is credited to a farmer’s account or made available to him/her without restriction. S/he does not need to have possession of it. If a farmer authorizes someone to be his/her agent and receive income for, the farmer is considered to have received it when the agent receives it. Income is not constructively received if receipt of the income is subject to substantial restrictions or limitations.
Similarly, if a farmer receives direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural Investment Act of 2002, s/he will not be considered to have constructively received a payment merely because s/he had the option to receive it in the year before it is required to be paid.
A farmer cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. Also, a farmer must report the income in the year the money or property is received or made available to him/her without restriction.
If debts of a farmer are paid by another person or are canceled by creditors, the farmer may report part or all of this debt relief as income. If income is received in this way, the farmer constructively receives the income when the debt is canceled or paid.
However, when a farmer sells an item under a deferred payment contract that calls for payment the following year, there is no constructive receipt in the year of sale. However, there are exceptions to this rule, for example: a farmer uses the cash method and a calendar tax year. He sells grain in December 2009 under a bona fide arm’s-length contract that calls for payment in 2010. He included the sale proceeds in 2010 gross income since that is the year payment is received. However, if the contract states that the farmer has the right to the proceeds from the buyer at any time after the grain is delivered, he must include the sale price in 2009 income, regardless of when he actually receive payment.
If a farmer include an amount in income and in a later year s/he has to repay all or part of it, then s/he can usually deduct the repayment in the year in which it is made. However, if the repayment is more than $3,000, a special rule applies.
Under the cash method, generally a farmer deduct expenses in the tax year when it is paid. This includes business expenses for which the farmer contest liability. However, s/he may not be able to deduct an expense paid in advance or s/he may be required to capitalize certain costs.
Generally, a farmer cannot deduct expenses paid in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.
Under an accrual method of accounting, generally the farmer report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to correctly match income and expenses. Certain businesses engaged in farming must use an accrual method of accounting for its farm business and for sales and purchases of inventory items.
An accrual method farmer’s gross income for a tax year is the sum of:
- the sales price of all livestock and other products held for sale that are sold during the year;
- the inventory value of livestock and products;
- all miscellaneous income items, e.g., fees from breeding, renting teams, machinery or land, or other incidental farm income;
- all subsidy and conservation payments includible that year; plus
- gross income from all other sources.
Generally, a farmer includes an amount in income for the tax year in which all events that fix his/her right to receive the income have occurred, and s/he can determine the amount with reasonable accuracy. If a farmer keeps an inventory, generally s/he must use an accrual method of accounting to determine his/her gross income.
Under an accrual method of accounting, a farmer generally deduct or capitalize a business expense when both of the following apply.
- The all-events test has been met. This test is met when:
- All events have occurred that fix the fact that you have a liability, and
- The amount of the liability can be determined with reasonable accuracy.
- Economic performance has occurred.
Generally, a farmer cannot deduct or capitalize a business expense until economic performance occurs. If his/her expense is for property or services provided to him/her, or for use of property, economic performance occurs as the property or services are provided or as the property is used. If a farmer’s expense is for property or services provided to others, economic performance occurs as s/he provide the property or services.
An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred.
Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until a farmer makes the payment and the corresponding amount is includible in the related person’s gross income. The relationship for this rule is to be determined as of the end of the tax year for which the expense or interest would otherwise be deductible.
The following businesses, if engaged in farming, must use an accrual method of accounting.
- A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning after 1975.
- A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
- A partnership with a corporation as a partner.
- A tax shelter.
If a farmer is required to keep an inventory, s/he should keep a complete record of his/her inventory as part of farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight, if applicable.
When a farmer uses accrual method of accounting in the hatchery business s/he must include in inventory, eggs in the process of incubation.
All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory. Also, supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct the cost of supplies in the year used or consumed in operations. However, do not include incidental supplies in inventory as these are deductible in the year of purchase.
Livestock held primarily for sale must be included in inventory. In the case of livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. If the farmer is in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes.
Generally, growing crops are not required to be included in inventory. However, if the crop has a preproductive period of more than two years, the farmer may have to capitalize or include in inventory costs associated with the crop.
A farmer should include in inventory all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.
The following applies if a farmer is required to use an accrual method of accounting.
- The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is two years or less.
- The costs of animals are subject to the uniform capitalization rules.
A farmer using inventories must use that method for:
- all livestock and poultry held primarily for sale;
- a hatchery business, eggs in incubation and growing and pre-market chickens;
- all harvested and purchased farm products held for sale, feed, or seed, e.g., as grain, hay, ensilage, concentrates, cotton, tobacco; and
- supplies, unless only small amounts are on hand.
The methods of inventory valuation are:
- Lower of cost or market.
- Farm-price method.
- Unit-livestock-price method.
If a farmer value his/her livestock inventory at cost or the lower of cost or market, s/he does not need IRS approval to change to the unit-livestock-price method. However, if s/he value livestock inventory using the farm-price method, then s/he must obtain permission from the IRS to change to the unit-livestock-price method.
A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property.
The following examples compare the cash and accrual methods of accounting:
- You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain in December 2009 but you are not paid until January 2010. You must both include the sale proceeds and deduct the costs incurred in producing the grain on your 2009 tax return.
- Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2009. Under this method, you include the sale proceeds in income for 2010, the year you receive payment. Deduct the costs of producing the grain in the year you pay for them.
There are special methods of accounting for certain items of income and expense. One such method is crop method. Under this method, if a farmer does not harvest and dispose of his/her crop in the same tax year that s/he planted it, s/he can, with IRS approval, use the crop method of accounting. In this method, the farmer deducts the entire cost of producing the crop, including the expense of seed or young plants, in the year s/he realize income from the crop.
Other special methods of accounting apply to the following items:
- Farm business expenses.
- Farm income.
- Installment sales.
- Soil and water conservation expenses.
Generally, a farmer can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows his/her income and expenses and s/he uses it consistently. However, the following restrictions apply.
- If one use the cash method for figuring income, s/he must use the cash method for reporting his/her expenses.
- If one use an accrual method for reporting expenses, s/he must use an accrual method for figuring his/her income.
Once an accounting method is set up, one must receive approval from the IRS before s/he can change to another method. A change in accounting method includes a change in:
- overall method, such as from cash to an accrual method, and
- treatment of any material item, such as a change in method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method).